Carsales.com (ASX:CAR) released a trading update in mid-June. Here we assess the impact on the domestic business from ongoing declines in new vehicle sales. We also assess the implications for the balance sheet in light of a potential sale of the troubled Stratton business. Finally, we take a look at the chart of CAR and determine whether there is further upside from here.
Carsales.com is the largest aggregator of online automotive classified advertising in Australia. In its domestic business, the Company has relationships with consumers, manufacturers, dealers, financiers and insurers Accordingly, the domestic business derived revenue from online classifieds across three segments: Display advertising, Dealer advertising and Private advertising. In addition to its domestic operations (which account for over 75% of group revenue and overall enterprise value), the Company has interests in leading international automotive classified businesses, mostly in Korea and Brazil.
Domestic Business Continues to Struggle
The key messages from the trading update in relation to the performance of the domestic business is that:
i. Weakness in the Display segment has continued. This is driven by the advertising industry’s move towards programmatic digital advertising purchasing, which will continue to be a structural headwind. While the changes are putting pressure on pricing, Carsales still retains its premium pricing in the market. Accordingly, while the rate of revenue growth is expected to rebound in 2H19 from a weak 1H19 (where revenue declined by 16.5%), the rate of revenue decline for the Display segment is FY19 is now likely to be worse than initially thought.
ii. The rate of revenue growth for the Dealer segment is now likely to be less than initially thought. However it still remains solid given that lead volumes for used cars remain robust and is absorbing the weakness in new car sales (CAR’s new car inventory accounts for less than 20% of overall inventory on the domestic site).
iii. The rate of revenue growth for the Dealer segment is expected to slow in 2H19, relative to the +8% revenue growth reported for 1H19. This is due to the ongoing weakness on new vehicle sales (i.e. 14 consecutive months of negative growth) which account for 20% of inventory on the domestic website (Carsales.com).
Gearing Level Remains Elevated but Still Serviceable
The overall level of gearing (on a net debt/EBITDA basis) was 2.14x as at 31 December 2018. It remains elevated following the acquisition of the remaining 50.1% stake in SK Encar from South Korean company SK Holdings Co. This was completed in January 2018 and partly debt funded. We estimate that a sale of the Stratton business may reduce gearing to ~1.6x on a FY20 EBITDA basis. This assumes that Stratton is sold for anywhere near the purchase price of $60m paid by CAR in 2014. However, book value for Stratton as at FY18 was much lower at ~$14m.
Fundamental View of Carsales.com
At the June trading update, the Company maintained earnings guidance for FY19. In light of declining revenue expectations (from ongoing challenges in the domestic business), the guidance was maintained largely as a result of cost control. In particular, operating expenditure growth for the core domestic business has been running at 5-6% and was pulled back to ~3.5% growth in 1H19. This was as employee cost growth has abated and the Company has been more targeted with their marketing investments. The improving cost performance appears to have continued into the current half.
While costs are currently supportive of earnings, we consider that there is a risk to earnings over the short-to-medium term. This is given that cost performance cannot continue to support earnings in light of the more challenging conditions for the core domestic businesses.
Further, there is now a greater reliance on CAR’s key international assets (i.e. Korea, Brazil) to drive CAR’s earnings growth going forward. While these businesses are performing very well and have longer-term growth opportunities (in particular SK Encar), it is worth noting that earnings from the international assets are higher-risk.
Accordingly, we take a cautious view on CAR’s fundamentals and note that the shares are currently trading on a 1-year forward P/E multiple of ~23x. This P/E is broadly in line with the average multiple since FY13 (which has ranged from 20-25x).
Charting View of Carsales.com
For the moment, CAR is trading well and it is likely to head higher in the short term. An obvious target would be resistance near $15.50. If CAR does take a dip here, then the next level of support that investors should aim for would be about $13.20.
(Please note: Carsales.com is due to report their FY19 results on 21 August.)
Michael Gable is managing director of Fairmont Equities.
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